Wednesday, July 20, 2011

A deficit reduction bill should push interest rates higher

Markets got excited yesterday at the prospect that Congress may be closing in on a bipartisan deficit reduction bill. 30-yr Treasury yields fell 12 bps, as investors reasoned that a reduction in federal debt issuance would lead to higher prices for Treasury debt. (Much of that drop in yields has been reversed so far today.)

I think this is one of those times when the bond market's initial reaction to some new and important development is wrong, or at least not well thought out.

To understand why, it is important to realize that yields on Treasury notes and bonds are fundamentally determined by inflation and inflation expectations. Inflation expectations, in turn, can be impacted by the market's perception of the economy's strength, because the market, and the Fed, believe that strong growth can add to inflation pressures, while weak growth creates deflationary pressures.

It's also important to understand that every bond issued in dollars is priced relative to Treasuries of a comparable maturity. Since Treasuries are the risk-free bedrock of the dollar-based bond market, non-Treasury securities have to pay a higher yield, or spread. That spread can change, of course, but if Treasury yields rise significantly, then it's a safe bet that the yields on all bonds will rise significantly.

The larger point here is that a change in the yield on Treasuries affects the yields on all bonds. Treasuries do not exist in isolation.

Our current $1.3 trillion federal deficit is a fairly large percentage of the $9.7 trillion of Treasury debt held by the public (about 13.5%), but the marginal borrower (in this case the U.S. government) does not set the price of the outstanding stock of U.S. debt, which is more than $30 trillion. Even very large $2 trillion deficits would have little impact on the level of bond yields, because the new supply of bonds would still be only a small fraction (6-7%) of all the investment-grade and high-yield bonds outstanding in the U.S. market. And I'm not even considering the more than $30 trillion in liquid, non-U.S. bonds outstanding in the world. Let me hasten to add that new Treasury issuance need not have any direct impact on inflation fundamentals, unless the Fed takes action to expand the money supply by more than the world desires.

Whether the federal government borrows $2 trillion or $1 trillion in the next year is not going to have much of an impact on the level of interest rates, taken in isolation, because the outstanding stock of bonds is orders of magnitude bigger. What could have a meaningful impact on interest rates, however, is how meaningful the package of spending cuts turns out to be. Many worry that a big cut in spending would weaken the economy, and that in turn would lead to lower inflation and lower interest rates.

But I think that a big cut in future spending would have a positive impact on the economy, since it would free up resources that can be better utilized by the private sector, and, by reducing future deficits, it would greatly increase the expected after-tax returns to investment. Combined, this could prove to be a powerful stimulus to growth. And so I think that upon reflection, a serious debt reduction package would eventually be perceived by the market to be good for the economy and therefore "bad" for the bond market, and that would mean higher, not lower yields.


Benjamin Cole said...

Excellent analysis by Scott Grannis--but even with a robust US recovery, there is a global Niagara of capital out there and extremely low inflationary pressures.

Get used to very low interest rates. Greg Mankiw said rates may go lower.

In a negative vein, I worry we are doing a Japan.

If you dare, look at inflation, interest rates and investment returns (losses) in Japan in the last 20 years (usually, I shield my eyes).

The global bond market is sizing up the current situation, but is not sure about prolonged deflation in the USA. It would be out of character of this nation.

But never have the gold nuts and tight-money crowd been so strong, and never has there been such a zeal and fetish in some circles for zero inflation--the moral virtue of zero inflation eclipse the positives of economic growth, we are told.

So, we may end up like Japan--no inflation and no growth. At least some people will be happy.

CINO said...


Somewhat off topic, but I was reading Gartman this morning and he went on a diatribe against central banks advocating for more and more capital requirements on banks. Of course, in order to raise capital a bank must shrink its balance sheet, which puts a damper on money velocity in the process, which is in essence contractionary.

Aside from the obvious hypocrisy of being in emergency-mode in regards interest rates and demanding that banks rev up their lending all while advocating for higher and higher capital requirements, what sort of inflationary consequences, if any, would arise if central banks, more specifically the Fed, began to calm their rhetoric in regards to capital requirements?

Scott Grannis said...

CINO: If the rhetoric over capital requirements were to cool off, this would, ceteris paribus, result in an increase in bank lending. Banks would be more inclined to put their excess reserves to work and expand the money supply. This would most likely exacerbate inflationary pressures.

chris said...

If you look at the economy from a financial accounting perspective then when the private sector is saving (like they currently are) and the capital account is in surplus (reflecting the negative trade balance) then if the governmnet reduces its fiscal deficit the other sectors have to reduce their savings or else the economy weakens. (Wynne Godley argument)
The trade sector is not likely to head into surplus in the near future (certainly not with oil prices rising) and the private sector seems to be a few years away from another dis-saving period. In the current scenario it is hard to see how increased government saving will not lead to slower economic growth.
I appreciate your argument but find it difficult to see how it will apply in the current abnormal environment.

Scott Grannis said...

chris: looking at the economy from an accounting perspective only makes things confusing. If the government reduces spending and borrows less, then there is more $ available to the private sector for investment. Plus, private sector investment is encouraged by a more responsible fiscal policy (or should I say a less irresponsible fiscal policy?), because reduced fiscal spending means a reduction in future tax burdens.

Scott Grannis said...

Demand for Treasuries is high (and rates are low) because of many factors (e.g., fear, weak growth expectations), and the potential contagion of a PIIGS crisis is clearly one of them.

chris said...

what happens when the household sector does not want to invest because their debts are too high and wealth has taken a extraordinary hit? That is when government deficits are necessary or else a recession (and in the current case, a depression)is likely. I agree that more fiscal responsibility by the government would promote more investment in the long run but my focus would be more on how they spend the money rather than how much they spend. How much they spend gets into the political realm and that gets messy! (I realize you are on one side of this issue) In the long run a more careful focus on investing government money in infrastructure or other productivity enhancing ventures is necessary but in the short run the economy is running on government life support; take it away too early and suffer the consequences.

Scott Grannis said...

chris: you may not have seen my posts on the subject of household financial burdens, total debt, and net worth. But they all show significant improvement in the past two years. Financial burdens (debt payments vs. disposable income) have fallen over 13%. Total debt has fallen by over $500 billion. Net worth is up $8 trillion.

Corporate profits are setting records, and households are in decent shape once again. What's holding the economy back is a reluctance to take risk. By spending tons of extra money, the federal government has absorbed the economy's available capital and largely wasted it. In the process the soaring deficits have signaled to investors that future tax burdens are rising. The expected after-tax return to investing is therefore falling.

The government is lousy when it comes to smart investing. The government spending multiplier is way below 1. Government needs to get out of the way; if it does, the private sector will almost certainly step in to take advantage of higher expected after-tax returns to investing. People always respond to incentives. We've been giving people the wrong incentives for years, and that's what needs to change.